WORKING CAPITAL MANAGEMENT
1 Concept of working capital
2 Need of working capital policy
3 Determinants of working capital requirement
4 Issues &Estimation of working capital requirement
Capital required for a business can be classified into fixed capital and working capital. Every business needs funds for two purposes for its establishment. Working capital is required to carry out day to day expenses. Long term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building; furniture etc. funds are also needed for short-term purpose for the purchase of raw material, payment of wages, and other day-to-day expenses etc. These funds are known as working capital
Long term funds are required to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc
Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. . It is otherwise known as revolving or circulating capital
It is nothing but the difference between current assets and current liabilities. i.e.
Working Capital = Current Asset – Current Liability.
1 Concept Of Working Capital
v Balance sheet concept
v Operating cycle or circular flow concept
Balance sheet concept
- Gross Working capital- It is the capital invested in the total current asset of the enterprise
- Net working capital- It is the excess of current assets over over current liabilities
Net working capital = current Assets – Current Liabilities
KINDS OF WORKING CAPITAL
v On the basis of concept
v On the basis of time
On the Basis of Concept
v Gross working capital
v Net working capital
On the Basis of time
Permanent or fixed working capital
It is the minimum amount which is required to ensure effective utilization of fixed facilities and for maintaining the circulation of current assets
v Regular working capital – circulation of current asset from cash to inventories and from inventories to receivables and from receivable to cash and so on.
v Reserve working capital – excess the amount of regular working capital which may be provided for contingencies that may arise at unstated period such as strikes, rise in
prices, depression etc
Temporary or variable working capital
It is the amount of working capital which is required to meet seasonal demands. It is classified in to seasonal and special working capital.
v Seasonal working capital – to meet the seasonal needs of the enterprise
v Special working capital – to meet special exigencies such as launching of extensive marketing campaign for conducting research etc.
2 Need Of Working Capital Policy
The various working capital policies are
Under this policy, finance manager will increase the amount of liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays his dues at maturity. But finance manger should not forget that the excess cash will not produce and earning and return on investment will decrease. So liquidity policy should be optimized.
Under this policy, finance manger will keep low amount of cash in business and try to invest maximum amount of cash and bank balance. It will sure that profit of business will increase due to increasing of investment in proper way but risk of business will also increase because liquidity of business will decrease and it can create bankruptcy position of business. So, profitability policy should make after seeing liquidity policy and after this both policies will helpful for proper management of working capital.
Matching or hedging approach/policy
This approach or policy is a moderate policy that matches assets and liabilities to maturities. Basically, a firm uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets
A fixed asset/equipment which is expected to provide cash flow for 8 years should be financed by say 8 years long-term debts .Assuming a firm needs to have additional inventories for 2 months, it will then sought short term 2 months bank credit to match it.
v Conservative because the firm prefers to have more cash on hands
v Fixed and part of current assets are financed by long-term or permanent funds
v As permanent or long-term sources are more expensive, this leads to ―lo wer risk lower return‖
v Having excess cash at off-peak period hence the need to invest the idle or excess cash to earn returns.
The firm wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.
3 Determinants of Working Capital Requirement
Nature or characteristics of Business
v Working capital requirement depends upon the nature o f its business
v Public utility undertaking like electricity, water supply and railways need very limited working capital because they offer cash sales only supply services not products.
v Trading and financial firm require less investment in fixed asset but invest large amount in current asset like inventories, receivables and cash.
v Manufacturing undertaking require working capital along with fixed investment
Size of Business / Scale of Operation
v Working capital requirement of a concern influenced by size of its business which is measured in term s of scale of operation
v Size of business unit large- require more working capital
v Size of business unit small – require less working capital
v Production is based on seasonal variation.
v Requirement of working capital depends on production policy.
v Production is seasonal less working capital
v Production is carried out throughout the year the working capital requirement is more
Manufacturing Process / Length of Production cycle
v Longer the process or period of manufacture, larger the amount of working capital is required
v Short the length of production cycle, smaller the amount of working capital requirement
v For certain industries raw material is not available throughout the year.
v They have to buy raw material in bulk during the season and process them during the entire year
v A huge amount is blocked in the form of inventories during such season which give rise to more working capital requirement.
v During busy season a firm requires larger working capital than in the slack season.
Working capital cycle
v In manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products.
v It refers to alternate expansion and contraction in general business activity.
v Boom period when business is prosperous – larger amount of working capital due to increase in sales
v Depression – sales decline, difficulties are faced in collection from debtors and firms may have larger amount of working capital requirement.
Earning capacity of the Firm
v Some firms have more earning capacity than others due to quality of their products, monopoly condition etc.
v Such firms with high earning capacity may generate cash profit from operation and to contribute to their working capital.
v Dividend policy influences the requirement of working capital.
4 Issues & Estimation Of Working Capital Requirement
v Components such as cash, marketable securities, receivables and inventory
v Working capital management requires much of the financial managers time.
v It has greater signifivcance for all firms but it is very critical for small firms
v The need for working capital is directly related to the firms growth.
Performa of the Working Capital Require ment
Curre nt Assets:
i) Cash XXXX
ii) Debtors XXXX
iii) Stocks XXXX
iv) Advanced payments XXXX
v) Others XXXX
Curre nt liabilities
i) Creditors XXXX
ii) Lag in payment of expenses XXXX
iii) Outstanding expenses if any XXXX
Working capital (Current assets-Current liabilities) XXXX
Add: Provision for contingencies XXXX
Net working capital required XXXX
Sources Of Working Capital
Working Capital require me nt can be normalized from short- term and long-term sources. Each source will have both merits and limitations up to certain extract. Uses of Working Capital may be differing from stage to stage.
• Retained Earnings
• Reserve and Surplus
• Depreciation Funds etc.
External sources Public
• Loans from Banks and Financial Institutions
• Advances and Credit
• Financial arrangements like Factoring, etc.
Determining the Finance Mix
Determining the finance mix is an important part of working capital manage me nt.
Under this decision, the relations hip among risk, return and liquidity are measured and also which type of financing is suitable to meet the Working Capital requirements of the business concern. There are three basic approaches for deter mining an appropriate Working Capital finance mix.
1. Hedging or matching approach
2. Conservative approach
3. Aggressive approach.
Hedging approach is also known as matching approach. Under this approach,
the business concern can adopt a financial plan which matches the expected life of
assets with the expected life of the sources of funds raised to finance assets.
When the business follows matching approach, long-term finance shall be used to
fixed assets and permanent cur re nt assets and short- term financing to finance
temporary or variable assets.
Temporary Current Assets
Under this approach, the entire estimated finance in current assets should be financed from long- term sources and the short- term sources should be used only for emergency requirements. This approach is called as ―Low Profit – Low Risk ‖ concept.
Under this approach, the entire estimated requirement of current assets should be financed from short- term sources and even a part of fixed assets financing be financed from short- term sources. This approach makes the finance mix more risky, less costly and more profitable.